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Chris Mullen and Peter Spina: A look at Britain''s Mr. Anti-Gold, Gordon Brown
Original Sin
By Stephen Roach, Chief Economist
Morgan Stanley Inc.
Monday, April 25, 2005
http://www.morganstanley.com/GEFdata/digests/20050425-
mon.html#anchor0
In all my years in this business, never before have I seen a central
bank attempt to spin the debate as America's Federal Reserve has
over the past six or seven years. From the New Paradigm mantra of
the late 1990s to today's new theories of the current-account
adjustment, the US central bank has led the charge in attempting to
rewrite conventional macroeconomics and in making an effort to
convince market participants of the wisdom of its revisionist
theories. The problem is that this recasting of macro is very self-
serving. It is a concentrated effort on the part of the Fed to
exonerate itself from the Original Sin of failing to address asset
bubbles. The result is an ever-deepening moral hazard dilemma that
poses grave threats to financial markets.
I am not a believer in conspiracy theories. But the Fed's behavior
since the late 1990s is starting to change my mind.
It all began with Alan Greenspan's worries over "irrational
exuberance" on December 5, 1996, when a surging Dow Jones Industrial
Average closed at 6437. The subsequent Fed tightening in March 1997
was aimed not only at the asset bubble itself, but at the impacts
such excessive appreciation in equity markets were having on the
real economy -- consumers and businesses alike.
It was a classic example of the Fed playing the role of the tough
guy -- the central bank that, to paraphrase the words of former
Chairman William McChesney Martin, "takes away the punchbowl just
when the party is getting good." Unfortunately, the tough guys
weren't so tough after all. Predictably, there was a huge outcry on
Capitol Hill as the Fed took aim on the US stock market. But rather
than stay the course as an independent central bank should, the Fed
ran for cover in the face of political criticism.
Not only were its initial bubble-containment efforts put aside, but
Alan Greenspan went on to champion the notion of a sea-change in the
macro climate -- a once-in-a-century productivity miracle that would
justify the stock market's exuberance as rational. That was the
Original Sin that has since been compounded in the years that have
followed.
Out of that pivotal moment in the late 1990s, a New Economy actually
did come into being.But it was not the new economy of ever-
accelerating productivity growth that infatuated the New Paradigm
Crowd and legions of equity-market speculators.Instead, it was
the Asset Economy that enabled consumers and businesses to draw on
the pixie dust of a new source of purchasing power -- asset
appreciation -- as a means to augment what has since turned into a
stunning shortfall of organic domestic income generation.
Unfortunately, the asset-based spending model has given rise to many
of the distortions and imbalances evident in the UStoday. That's
especially true of low saving rates, the housing bubble, high debt
loads, and a runaway current account deficit. When the equity bubble
burst, asset-dependent American consumers barely skipped a beat.
Courtesy of an extraordinary shift to monetary accommodation, the
pendulum of asset depreciation quickly swung into property markets;
US house-price inflation has since surged to a 25-year high.
To the extent that equity extraction from ever-rising property
appreciation was viewed as a substitute for organic sources of labor
income generation, hard-pressed consumers went deeply into debt to
monetize the windfall. As a result, household sector indebtedness
surged to nearly 90% of US GDP -- an all-time record and up over 20
percentage points from levels in the mid-1990s when the Asset
Economy was born.
Secure in the asset-driven spending posture that resulted, consumers
saw no need to save the old-fashioned way out of earned labor
income.That's why the personal saving rate has collapsed and
currently stands near zero.
Asset-based consumption is also at the core of America's current-
account problem. In an income-based accounting framework,
the "missing saving" has to come from somewhere. In this case,
that "somewhere" is the foreign saver -- giving rise to the current-
account and trade deficits required to attract the foreign
capital.
As a result, the US current-account gap probably exceeded 6.5% of
GDP in the first quarter of 2005 -- easily another record and well
in excess of the 4% deficit prevailing in the mid-1990s.
This whole story, in my view, remains balanced on the head of a pin
of absurdly low real interest rates.And the Fed has certainly
been pivotal in nurturing this low-interest-rate regime. In an
extraordinary display of policy accommodation, the real federal
funds rate is only now moving above the zero threshold after having
spent three years in negative territory.
Of course, a central bank has little choice to do otherwise if it
has made a conscious decision to underwrite the Asset Economy.
After all, it takes low interest rates to provide valuation support
to most financial assets -- initially stocks, then bonds, and now
property. Furthermore, it takes low rates to make refi debt --
and the equity extraction it sponsors -- look attractive from a
carrying cost perspective.
Low rates also discourage income-based saving by underscoring the
paltry returns available to savers in traditional asset classes. A
migration to riskier assets -- such as property and "spread"
products (i.e., high-yield and emerging market debt) -- is
encouraged as a result. And low real rates make it easier to
finance an ever-widening current-account deficit -- especially if
the incremental flows come from foreign central banks, where there
is reason to tolerate subpar returns in exchange for currency
competitiveness. In short, without low real interest rates, the
Asset Economy -- and all of its inherent imbalances and excesses --
is nothing.
The Fed is not only hard at work in the engine room in keeping the
magic alive with a super-accommodative monetary policy but is has
also become the intellectual architect of the New Macro.Time and
again, since Alan Greenspan rolled out his New Paradigm theory in
the late 1990s, senior Federal Reserve policy makers have taken the
lead role as proselytizers of a new macro spin that condones the
saving, debt, property bubble, and current-account excesses of the
Asset Economy. The examples are far too numerous to mention, but
consider the following highlights:
* Chairman Greenspan has made light of traditional measures of
household indebtedness -- even going so far as to urge consumers to
move from fixed to floating rate obligations (see his February 23,
2004, speech,"Understanding Household Debt Obligations." Note:
All references are to speeches available on the Fed's website at
www.federalreserve.gov).
* Fed governors have also borrowed a page from the Roaring 1990s in
denying the possibility of a housing bubble (see Chairman
Greenspan's October 19, 2004, speech,"The Mortgage Market and
Consumer Debt," and Governor Kohn's April 1, 2004, speech,
"Monetary Policy and Imbalances").
* More recently senior Fed officials -- namely, Chairman Greenspan,
Vice Chairman Ferguson, and Governors Bernanke and Kohn -- have
unleashed a veritable broadside against the time-honored notion of
the current-account adjustment (see their various 2005 speeches,
especially Governor Kohn's April 22 speech, "Imbalances and the
US Economy," Vice Chairman Ferguson's April 20 speech,"U.S.
Current Account Deficit: Causes and Consequences," andChairman
Greenspan's February 4 speech, "Current Account").
* Governor Bernanke has also led the charge in coming up with a new
theory of national saving -- that the United States is actually
doing the world a favor by absorbing a so-called glut of global
saving (see his April 14, 2005, speech,"The Global Saving Glut
and the U.S. Current Account Deficit"); Vice Chairman Ferguson has
been on a similar wavelength in dismissing concerns over subpar
personal saving (see his October 6, 2004, speech, "questions and
Reflections on the Personal Saving Rate").
Is this is an appropriate role for a central bank?In my view,
absolutely not. The problem with an activist central bank is that
decision makers in the real economy -- consumers and businesspeople
alike -- mistake the Fed's point of view for strategic advice.And
so do financial market participants. After hearing the Fed pound the
table, consumers feel left out if they don't spend their housing
equity.Business managers felt equally deprived in the late 1990s
if their companies didn't achieve the dotcom-type valuations in the
stock market that Chairman Greenspan insisted in the late 1990s and
even early 2000 were well-grounded in a once-in-a-century
productivity miracle. The resulting overhang of excess IT spending
was a direct outgrowth of this perceived deprivation.
Needless to say, when investors and financial speculators saw the
equity train leave the station and the Fed condone the high growth
of a productivity-led economy by leaving interest rates low, they
saw no reason to believe that a bubble was about to burst. When
consumers hear from a Fed chairman that it makes little sense to
take on fixed rate debt, they rush to floating-rate instruments; not
by coincidence, the adjustable rate portion of newly originated
mortgage debt shot up in the immediate aftermath of Chairman
Greenspan's comments on consumer indebtedness. And should asset-
dependent, saving-short, overly indebted American consumers feel at
risk if the Fed assures them that there is no housing bubble -- that
the asset-based underpinnings of their decision making are well
grounded?A record consumption share in the US economy -- 71% of
GDP since 2002 versus a 67% norm over the 1975 to 2000 period --
speaks for itself.
The rhetorical flourishes of America's central bankers have dug the
USeconomy -- and by definition, a US-centric global economy --
into a deep hole.To this very day, the Fed has never confessed to
the Original Sin of condoning the equity bubble. On the contrary,
Greenspan & Co. have been on the defensive ever since by dismissing
the increasingly dangerous repercussions of the original post-bubble
shakeout.
Far from playing the role of the tough guy that is required of
independent central bankers, the Fed has become an advocate of the
easy money of a powerful liquidity cycle.One bubble has since
begotten another -- from equities to bonds to fixed income spread
products (i.e., emerging market and high-yield debt) to property.
And financial markets have gone along for the ride -- not just in
the US but also around the world as global investors and foreign
central banks have rushed with reckless abandon to finance
America's record current-account deficit.
The day is close at hand when USmonetary policy must get
real.
At a minimum that will require a normalization of real interest
rates. Given the excesses that now exist, it may even require a
federal funds rate that needs to move into the restrictive zone --
possibly as high as 5.5%.
Yes, this would cause an outcry -- perhaps similar to that which
occurred in the spring of 1997 on the occasion of the Original
Sin.
But in the end there may be no other choice. Fedspeak has taken us
into the greatest moral hazard dilemma of all -- how to wean an
asset-dependent system from unsustainably low real interest rates
without bringing the entire House of Cards down. The longer the Fed
waits, the more perilous the exit strategy.
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